EurozoneEY Eurozone Forecast March 2014

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Spain

Spain

Portugal

France

Ireland

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Estonia

Latvia

Belgium

Slovakia

Austria

Slovenia

Italy

Greece

Malta Cyprus

Netherlands

Luxembourg

Germany

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Outlook for Greece

Exports hold the key to a medium-term recovery

Spain

Portugal

France

Ireland

Finland

Estonia

Latvia

Belgium

Slovakia

Austria

Slovenia

Italy

Greece

Malta Cyprus

Netherlands

Luxembourg

Germany

1EY Eurozone Forecast March 2014 | Greece

Highlights

• The Greek economy’s rate of contraction continued to slow toward the end of 2013, with GDP for the year as a whole down 3.7% from 2012. Unemployment is starting to level out and, with government finances (excluding interest payments) close to balance and the current account also close to zero, the outlook is much improved.

• But talk of a recovery is probably optimistic, and we expect GDP to contract by a further 0.5% in 2014. Abundant spare capacity will mean that wages continue to decline in the short term, pushing households’ disposable income down further, despite some relief from falling prices. Against this backdrop, we expect consumer spending to fall by 1% in 2014, offsetting much of the improvement in net exports.

• Given the weak domestic situation, Greece needs to capitalize from the pickup in world trade. The record to date is mixed, with strong international travel receipts compensating for disappointing goods exports. Despite this, a stronger Eurozone recovery and continued supply-side improvements point toward a more encouraging trade performance. Export growth is set to accelerate to 4.8% this year and around 4% a year in 2015–18.

• As exports pick up, firms will need to replace a depleted capital stock in order to realize the benefits from improved competitiveness and business reforms. Fixed investment is set to rise slightly this year and then grow by over 6% a year in 2015–18.

• Although the economic outlook has improved, the political landscape remains fractious. And international relations also appear strained, with multilateral lenders pressuring the Government to make faster progress on structural reform.

GDP growth

2014

–0.5% GDP growth

2015

1.7%

Unemployment

2014

28.3%

Consumer prices

2014

–0.7%

2 EY Eurozone Forecast March 2014 | Greece

Exports hold the key to a medium-term recovery

Optimism checked by weak domestic fundamentals

The Greek economy’s rate of contraction continued to ease toward the end of 2013. External and fiscal imbalances are much improved and manufacturing output has nearly stabilized. The latest Purchasing Managers’ Index climbed to its highest level in more than four years. Unemployment also seems to be stabilizing and confidence indicators point to some very cautious optimism for the start of 2014. Unsurprisingly, Greek authorities are fully backing the recovery, forecasting GDP growth of 0.6% in 2014 and even exploring a possible return to international capital markets.

The outlook is indeed brighter, but the performance of the economy over the recent few years has lowered standards for what might be considered “good news”

in Greece. There is still much work to be done. The country has a very high unemployment rate, government debt is probably unsustainable and domestic demand remains weak. Furthermore, deflationary pressures present a real risk to the recovery. We therefore expect the economy to continue on its downward path in 2014, as falling private consumption offsets any improvement in net exports, with GDP forecast to contract by 0.5%.

Households continue to see disposable incomes squeezed

As the dominant component of GDP, our short-term forecast is underpinned by the expectation that private consumption will continue to fall this year. Households have been subjected to a 34% real-terms decline in their incomes over the last five years, with rising unemployment and falling wages having a negative effect on living

standards in Greece. This trend is set to continue in 2014. Abundant spare capacity in production and the exceptional amount of slack in the labor market will mean that wages decline further in the short term. Consumer spending is expected to fall by 1% in 2014, before seeing muted growth over the forecast period, as the large output gap keeps wage growth in check.

The level of unemployment showed signs of tailing off toward the end of 2013 and so looks to be approaching a cyclical turnaround, with a peak at around 28.4% in mid-2014. As the recovery materializes over the medium term, the level of job creation should rise in parallel with an increase in aggregate demand. But even if GDP growth accelerates beyond expectations, growth is unlikely to be strong enough to generate a significant improvement in labor market conditions,

Table 1

Greece (annual percentage changes unless specified)

2013 2014 2015 2016 2017 2018

GDP –3.7 –0.5 1.7 1.7 2.3 2.2

Private consumption –6.5 –1.0 0.9 1.3 1.4 1.6

Fixed investment –11.7 0.6 6.2 6.2 6.1 5.8

Stockbuilding (% of GDP) 1.8 0.8 0.6 0.1 0.2 0.1

Government consumption –6.4 –4.6 –0.6 1.7 1.7 1.6

Exports of goods and services 2.5 4.8 4.0 4.0 3.9 3.8

Imports of goods and services –5.0 –2.3 2.2 3.2 3.6 3.8

Consumer prices –0.9 –0.7 0.5 1.1 1.6 1.8

Unemployment rate (level) 27.5 28.3 27.6 26.7 25.7 24.6

Current account balance (% of GDP) –0.2 –0.4 0.0 0.1 0.2 0.3

Government budget (% of GDP) –4.9 –3.8 –3.0 –2.5 –2.1 –1.9

Government debt (% of GDP) 171.0 173.6 171.7 168.2 163.2 158.2

ECB main refinancing rate (%) 0.5 0.3 0.3 0.3 0.4 1.4

Euro effective exchange rate (1995 = 100) 120.8 120.7 118.0 115.8 114.8 114.7

Exchange rate ($ per €) 1.33 1.30 1.25 1.22 1.20 1.20

Source: Oxford Economics.

3EY Eurozone Forecast March 2014 | Greece

Table 2

Forecast for Greece by sector (annual percentage changes in gross added value) 2013 2014 2015 2016 2017 2018

GDP –3.7 –0.5 1.7 1.7 2.3 2.2

Manufacturing –2.7 –0.1 1.4 1.6 2.4 2.6

Agriculture –5.6 –1.5 0.8 0.6 1.3 1.5

Construction –20.6 3.1 3.8 3.6 3.2 3.0

Utilities –0.3 3.9 5.0 2.9 3.1 2.8

Trade –4.9 –0.9 1.4 1.5 2.5 2.6

Financial and business services –0.6 0.7 1.5 1.0 1.9 1.8

Communications 1.9 5.7 6.8 4.0 4.0 3.4

Non-market services –5.6 –3.4 0.4 2.0 2.0 1.7

Source: Oxford Economics.

Figure 1Contributions to GDP growth

Source: Oxford Economics.

% year

–12

–10

–8

–6

–4

–2

0

2

4

6

8

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017

Forecast

GDP

Net exports

Domestic demand

Figure 2Unemployment

Source: Oxford Economics.

%

0

5

10

15

20

25

30

2002 2004 2006 2008 2010 2012 2014 2016

Forecast

and unemployment is set to remain at elevated levels for an extended period of time.

Meanwhile, the rate of youth unemployment (15–24 year olds) is approaching 60%. And with many universities all but closed due to ongoing industrial action, the prospects for young people in Greece are limited. As well as the short-term problems associated with such high levels of unemployment, the implications for medium- to long-term growth in Greece are worrying. Unless the Government can mobilize the younger generation, the country may see large outward migration as young professionals are forced to travel abroad in order to find work. This will further compound unfavorable demographics in Greece, driven by an aging population and declining birth rate, by increasing the dependency ratio and reducing the contribution of labor supply to potential output growth.

Deflation is a risk to the recovery

Deflation emerged as a growing concern in the second half of 2013, as the ongoing collapse in domestic demand and falling wages finally fed through to consumer prices. In November, consumer prices posted a record decline of 2.9% on a year earlier — following a special 10-day nationwide retail sales period, introduced under new legislation aimed at liberalizing the retail sector — before easing back to a fall of 1.5% in January. Deflation will provide some

welcome relief to consumers in the short term, but the worry is that, with prices falling, consumers may increasingly defer non-urgent purchases in the expectation that prices will continue to fall. This would lead to a deflationary spiral from which it would be difficult to emerge. And a persistent period of deflation would represent a serious threat to the recovery by increasing the real debt burden, both for the Government and for highly indebted households. It would also undermine the continued adjustment in real wages that is necessary to improve the competitiveness of the industrial sector.

Weak demand and continued regulatory reform will lead to further price falls in the short term. But, as the recovery in economic activity comes through, we expect prices to stabilize toward the end of the year and then start rising again from 2015.

Impetus from exports will be crucial to the recovery

Given the scale of domestic troubles, the Greek economy needs to capitalize on the pickup in world trade expected over the next few years if it is to experience a solid turnaround in fortunes. Overall, export growth was encouraging in 2013, driven by a strong rebound in tourism. International travel receipts rose by about 15% from 2012, as the tourism sector benefited from continued political tensions in competing destinations.

4 EY Eurozone Forecast March 2014 | Greece

Exports hold the key to a medium-term recovery

Figure 3Prices and wages

Source: Oxford Economics.

% year

–6

–3

0

3

6

9

12

15

18

1995 1998 2001 2004 2007 2010 2013 2016

Forecast

Consumer prices

Wages

Figure 4Government deficit and debt

Source: Oxford Economics.

% of GDP % of GDP

0

20

40

60

80

100

120

140

160

180

200

1995 1998 2001 2004 2007 2010 2013 2016–18

–16

–14

–12

–10

–8

–6

–4

–2

0

Forecast

Government deficit(left-hand side)

Government debt(right-hand side)

And with the depressed state of domestic demand, further import shrinkage has helped to push the current account deficit down to close to zero. This represents a significant adjustment. In 2007, the current account deficit was approaching 15% of GDP. But stripping out the impact of tourism and fuel, the volume of goods exports actually contracted by 2.2% in 2013. This suggests that Greece is not producing enough tradable goods, despite a dramatic improvement in competitiveness. The worry is that, as the economy turns the corner, renewed import growth may push the current account back into a large deficit.

Despite this, several factors point toward improved export performance in the future. This year will see a positive contribution from net trade, although it will not be sufficient to outweigh a fall in consumer spending, driven by another strong tourism season and further import compression. Over the medium term, supply-side developments, driven by the continued adjustment in unit labor costs and structural reform, coupled with a demand-side response generated by a more robust Eurozone recovery, should see export growth averaging just under 4% a year in 2015–18.

As exports pick up, firms will need to update a depleted capital stock in order to realize the benefits from improved competitiveness and business reforms. Investment levels are expected to stabilize this year, following six successive years of double-digit falls. The level of fixed investment has fallen by 65% in real terms since the start of the crisis. Over the medium term, supported by a more business-friendly environment and a much healthier banking system, business investment expenditure is expected to grow by about 6% a year in 2015–18. But despite this, as an illustration of just how far businesses have scaled back their operations, the level of real investment in 2018 is still expected to be lower than in 1998.

Sustainability of public debt remains a pressing issue …

The fiscal balance is also much improved. After operating at an overall deficit of nearly 16% of GDP back in 2009, it now appears that the Government managed to generate a small primary surplus (which excludes interest payments) in 2013. Preliminary data puts the central government surplus at around €600m, but this may rise to more than €1b after revisions (full accounts are not due until April). Whatever the final figure, achieving a primary budget surplus should trigger fresh discussions with creditors on new debt-relief

measures, returning to an earlier promise made by European partners. The medium-term strategy implies an increase in the primary budget surplus toward 3% of GDP in 2015 and 4.5% in 2016. But with gross government debt already above 170% of GDP, heavy interest payments will mean the government continues to run an overall budget deficit for the foreseeable future. Servicing this debt will place a considerable drag on growth and so Greece will need to reduce its annual financing costs if the recovery is to gain any momentum.

In the meantime, officials have spoken of a desire to recycle much of the surplus money back into the economy. But with the banking sector needing further capital injections, and the European Union, the European Central Bank and the International Monetary Fund yet to sign off the 2014 budget over a disagreement over a projected gap in public finances, the need for further austerity may mean fresh cuts in government spending.

… as pressure on the Government intensifies

Despite the economic outlook improving significantly over the last 12 months, the political landscape remains fractious. Unsurprisingly, since it came to office, support for the coalition of New Democracy and PASOK has suffered, as people have been forced to endure successive bouts of austerity measures. As a consequence, support for the left-wing Syriza party, with its strong anti-bailout rhetoric, has grown.

Meanwhile, the Government remains locked in negotiations with international creditors. The major stumbling block concerns the slippage in structural reform. Reforms targeting domestic competition, labor market mobility and restrictive regulatory burdens are fundamental to the recovery and should boost long-term growth. But the pace of structural reform so far has been too slow. The same is true for the privatization program, which failed miserably to hit revenue targets for 2013. The next tranche of bailout funds will only be released once the assessment is completed. Although Greece is in no immediate need of financing (the next big debt redemption date is not until May 2014) the Government will want to secure funding sooner rather than later. But continued political wrangling may further delay the pace of reform, and such a scenario could quickly push the yields of Greek bonds above 10% once again.

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